Insurers have developed a habit of using their reserves to boost their results and shield them from the economic storm. But will this provide much protection when EU directive Solvency II blows into town?

This year’s Top 50 research from Standard & Poor’s shows just how much many insurers have come to rely on using their reserves to make their results appear more impressive. But increasingly this looks like flimsy protection against the economic storm. Fears have been raised that resources are dwindling, and another dark cloud is looming on the horizon: Solvency II. Here, we look at how the incoming EU rules are likely to leave some insurers feeling decidedly bedraggled.

Massive volatility

The full details of the new directive, which is due to come into force in 2013, have yet to be finalised, but it is clear that it will require insurers to take a more precise approach to setting their reserves and force many to be more prudent. In other words, they will be forced to set aside more to cover potential losses than they do at present. As a consequence, many will find they are able to release less.

AXA group finance risk and strategy director Jean Drouffe says: “We expect reserving standards to be much more prescribed – until now we have had more freedom – and as a result we will see insurers reserving more prudently.” He says he expects to see the average reserve releases falling from their current levels of 5%-10% of premium to 2%-3%.

This, Drouffe warns, will lead to dramatic levels of volatility in insurers’ results. “We use reserves as an important lever for smoothing earnings but in future we will not have that, so the volatility of insurers will be shown much more. This is good in a way, as it will show a truer picture, but it will show massive volatility.”

This is unlikely to impress investors, and that will impact on share prices. Drouffe adds: “It’s already happening actually – insurance companies are trading at a discount. However, I think people are in fact still underestimating the volatility to come.”

This is not the only thing that will put investors off the sector: insurers may also need to cut dividends. Shore Capital analyst Eamonn Flanagan says this is happening already. “We are seeing companies disappointing investors in terms of dividends, seemingly because they are saving up to meet Solvency II requirements. In 2007, a number of insurance companies returned capital to investors, but in future I think that will be less likely.”

Pricing for profit

So how else to make a profit and smooth out volatility when the protective shield of reserves has been removed? For one, insurers will have to push prices up. Flanagan argues that insurers should be doing this already, but so far the fragmented nature of the market has militated against price increases.

Flanagan says: “UK household and motor are not fragmented – for example, five providers hold 60% of the motor market – so you do get rate rises in these markets.” But most experts agree insurers will have to start pricing for profit, come what may.

Drouffe adds that pricing will become more sophisticated. “At the moment we do a lot of averaging to deal with being too expensive on some products and cheaper on others, but in future there will be more precision.” This, he says, will lead to more firms specialising as they focus on lines of business they can price accurately and sell off those they cannot – not a particularly desirable scenario if the sector’s share prices are hit, as predicted.

An exercise in self-deception

To understand just how painful the habit of releasing reserves will be to kick, let’s look at how insurers became so dependent in the first place. It started with prices taking a hit due to the rise of price comparison websites and claims farming, and has been compounded by the global downturn’s impact on investment returns, which could otherwise have beefed up profits. This has left insurers with nowhere else to turn when shoring up their balance sheets.

Deloitte partner Gurpreet Johal says that releasing reserves became a common way of masking poor underwriting results: “In recent years, claims inflation has been higher than premium inflation in the UK motor market, where premium rises have until recently been minimal. For the majority of other classes of business, with the exception of UK household, premiums have actually been falling.

“As a result, underwriting results have been deteriorating. However, for many classes of business the declared results were better than the pure year results as insurers have been releasing surplus claims reserves to bolster their underwriting profitability.”

So far this has been working: the reported net combined ratio of non-life insurers has been stable for the past few years to an almost unprecedented degree, not exceeding 101% since 2001. S&P says that reserve releases have improved the ratio by between 5.0 and 8.9 percentage points in each of the past five years. Data from the FSA also shows the industry recorded an underwriting profit in five of the past seven years, with 2007 and 2008 being the exceptions, and an aggregate profit for the period of £3.7bn.

But under Solvency II, this ability to smooth out results with reserves will decrease, meaning, as Drouffe says, “the effects of financial downturns on insurers will be more obvious”. Worryingly in light of the heavy reliance on reserve releases, a report from SunGuard in October revealed that only 37% of board-level executives view Solvency II as “front of mind”. Now is the time to start prioritising preparations for the directive – and stop ducking behind your reserves. IT

Calculating reserves under Solvency II

PricewaterhouseCoopers partner Paul Clarke says: "The new rules require reserves to be based on a best estimate, that is, reserves for future claim payments should be the discounted, probability-weighted average of future cash flows without an allowance for prudence. Plus, there will be a risk margin on top of that, which is intended to reflect the amount a third party would require to take over the insurance liability."

Until now general insurance companies have used generally accepted accounting principles as the basis of regulatory reporting and "have probably had more flexibility to reflect their own levels of prudence".

(The larger life companies currently produce valuations within a market consistent framework, but the move to Solvency II will involve a change in methodology for all insurers.)

At present insurers are taking part in the Quantitative Impact Study 5 dry run of Solvency II. A Towers Watson survey in May found that 30% of them said that determining the risk margin would be the most challenging aspect of the balance sheet, followed closely by determining best estimate liability.